Technical Difficulties

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The Victorian-era Imperial Hotel in Chestertown, Maryland, is partly owned by its de facto finance chief, Judith O’Dell, and her husband. Like many small-business owners, O’Dell uses the off-the-shelf software package QuickBooks to manage the Imperial’s finances.

O’Dell, it should be noted, is no finance neophyte. In addition to her hotel duties, she also runs O’Dell Valuation Consulting LLC, a tax and accounting services firm, and is chair of the Financial Accounting Standards Board’s Private Company Financial Reporting Committee.

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Therefore, the findings of an accounting experiment she conducted earlier this year will be of interest to many finance executives.

Adhering to the financial statement presentation rules laid out in a proposal issued by FASB, which require the direct method of cash-flow accounting, O’Dell assessed whether her software application was up to the task. The direct method requires more disaggregation of entries, while the more accepted indirect method divides cash flows into two large buckets: cash received from customers and cash paid to employees, suppliers, and vendors.

The result? “I couldn’t do it,” she says. “I could not extract the information and the detail required for the direct method, so I had to [manually] plug in the numbers.” O’Dell believes that many of the dozen or so rulemaking projects FASB aims to finish by next year will cause similar problems for a range of software systems.

Ironically, the Big Bang switch from generally accepted accounting principles to international financial reporting standards may pose far less of an IT challenge, because software vendors have already modified their applications for companies operating in countries where that switch has taken place.

In contrast, individual FASB rule proposals on revenue recognition, lease accounting, and a host of other issues may pose far greater technical difficulties. FASB officials say the board is fully aware of the possible IT implications of its proposals, and communicates regularly with software vendors and other stakeholders about how to head off potential obstacles.

So far no one is reaching for the panic button. Vendors across the spectrum, from enterprise resource planning (ERP) giants SAP and Oracle to integrated financial reporting vendors such as NetSuite to more specialized vendors like International Decision Systems, which makes lease-accounting software, say they will take the rule changes in stride and upgrade their systems when rules are finalized.

Nevertheless, software vendors have asked FASB to consider a “cost containment” measure that would cluster compliance deadlines for major rule changes, so companies that need to modify software systems can do so all at once, rather than piecemeal as various effective dates kick in.

In a report from FASB, the board has acknowledged software vendors’ concern that the less uniform a company’s accounting and reporting systems are, “the more difficult and costly it could be to implement the proposed requirements.” Here is a look at four of the more prominent IT problems companies will face as the rulemaking proceeds.

Financial Statement Presentation: A Direct Hit

While lenders and analysts are big fans of the direct cash-flow method being prescribed by FASB’s financial statement presentation project, “it’s a nightmare for preparers,” asserts O’Dell. The project fundamentally changes the way information is presented on the balance sheet, income statement, and cash-flow statement by separating a company’s business activities from its financing or funding activities.

“We don’t collect this type of information [required by the direct method],” noted David Bond, senior vice president of finance and control for Safeway, at a recent conference. Fellow panelist Steve Whaley, controller for Wal-Mart Stores, agreed: “That’s not the way our ERP system is set up to do things.”

Jay Hanson, national director of accounting with McGladrey & Pullen and a member of FASB’s Emerging Issues Task Force, calls the direct cash-flow method one of the “poster children” for the difficulties preparers will face with the financial statement presentation project. The method requires companies to start with the net income number, and add or subtract working-capital items to get down to cash flow from operations. It also requires companies to add lines that break down items into such categories as cash received from customers, cash paid to customers, and cash paid to employees.

The only way to track “real” direct cash flows is to devise a system that captures data that likely exists at the lowest levels of an organization but is not currently being extracted. From an IT perspective, that means unearthing data that can be used to support accounting-treatment judgments and fair-value estimates, testing its integrity, and building a “formal disciplined process” around reporting the data, says Steve Hobbs, a managing director with consulting and internal-audit firm Protiviti.

Lease Accounting: A Capital Idea

The right-to-use concept written into FASB’s lease rule proposal (Topic 840) essentially eliminates operating leases for equipment and real estate rentals that extend beyond 12 months. If the rules are issued in their current form, companies that lease property or equipment will have to capitalize affected operating leases and bring the associated assets and liabilities back onto balance sheets.

At the same time, lessors will be required to make risk-based assessments before choosing between two prescribed accounting models, either the “performance obligation” if lessors retain the asset risk, or the “derecognition” model if risk is transferred to the lessee. Either way, lessors must periodically estimate — on a lease-by-lease basis — the fair value of assets and liabilities.

This new influx of valuation and other data is reminiscent of “the Y2K transition,” says McGladrey audit partner Morris Oldham. Data fields constructed to handle, for example, up to $999 million in leases may have to be reworked to accept $1 billion or more in such assets.

Furthermore, the draft rule requires that lease contingences, such as lease payment or receivables based on percentage of sales, be recorded differently. Under the proposed rule, lessees and lessors are required to churn out estimates for future payment and receivables. While retailers know how much they pay in rent, “they just don’t have systems that calculate how much they will have to pay in the future,” says Ross Prindle, managing director of the real estate group for Duff & Phelps.

Software also must be upgraded to troll for buried items — such as the term over which lease payments will be made or received, or the probability that a tenant will exercise an option to extend its lease. Accounting systems must first find the data, then extract it in a way that can be reported in financial statements, Oldham says.

Katie Emmel, director of product management and support at IDS, says that the lease accounting upgrades will take about three months to complete for smaller companies with simple accounting systems, and up to a year for large multinationals.

Financial Instruments: Losing Bankers’ Religion

FASB hit a nerve when it issued an exposure draft in May on financial instruments (Topic 825) and derivatives and hedging (Topic 815). In the four months the proposal was out for public comment, the board received 1,525 comment letters, prompting FASB to schedule three public meetings on the subject last month.

Wells Fargo executive vice president and controller Richard Levy took issue with FASB’s expanded use of fair value on several fronts, including IT. “Existing accounting systems cannot accommodate the proposed fair-value and credit-impairment guidance” being proposed in FASB’s rules, wrote Levy. Specifically, he pointed out that loan-accounting systems are unable to track fair value separately from amortized cost, calculate and store expected cash-flow information, or handle the proposed changes to interest-income recognition. He also complained that credit, deposit, security, and risk-management systems would be handicapped by the proposed rules, essentially requiring “companies to significantly enhance or, in certain cases, replace entire financial-reporting systems.”

Henry Wysocki, senior counsel at The Clearing House Association, underscores other IT problems related to loan-impairment accounting. For example, while impairment accounting is mostly handled outside the loan-accounting system, the proposed rule requires banks to introduce a “second accounting system” to determine impairment. Integrating the two systems, says Wysocki, would be “expensive and complex and subject banks to significant operational risk if manual processes are required as an interim solution.”

Revenue Recognition: It’s All Relative

Fair-value methodology — in this case involving the requirement to use the so-called relative selling price method to book bundled products — also looks to be the major IT challenge for revenue recognition. While current revenue rules require the relative pricing method, they also give companies the option to use the less onerous residual method of accounting if estimating the value of individual interlocking pieces of a contract becomes too difficult.

Earlier adopters of the revenue-recognition rules — such as Apple, Cisco, and NetSuite — spent about 50% of their conversion effort on “planning and scoping” the project, says Protiviti’s Hobbs. Smaller companies with less-sophisticated accounting systems will have to do the same, since no off-the-shelf software “will work without a fair amount of customization — the new rules are just too complex.” He would rather see companies make IT infrastructure changes.

Yet spreadsheets and temporary software patches may be the approach many small and midsize companies take, says Hobbs. He suspects smaller companies may be “tempted to work around” the rule changes to get through the initial year of reporting. The risk, however, is that “Band-Aids often don’t work, because there isn’t the time or budget later on to do what needs to be done.”

The “heavy lifting won’t be getting the accounting right,” asserts Hobbs, but rather building processes and systems that are “sustainable quarter after quarter.”

Marie Leone is senior editor for accounting at CFO.

Rippling Rules

The unintended consequences of proposed accounting rules could change the way companies do business. Lewis Beatty, CFO of First Hope Bank, speculates that the draft rules for financial instruments could force community banks to abandon long-term fixed-term loans and products for more volatile offerings — such as derivatives or loans with balloon payments. In a comment letter to the Financial Accounting Standards Board, Beatty wrote that the rules would push banks to shift interest-rate risk to customers as a way of maintaining capital ratios. As a result, conventional financial products — the core of community banks — would be replaced by riskier fare.

Hospitals will feel the sting of lease-accounting rules, says William Bosco, a consultant who regularly works with the Equipment Leasing and Finance Association. Bosco says the proposal replaces rent expense with asset amortization and interest expense, two items for which Medicare does not issue reimbursements. That means hospitals that lease nonmedical equipment will lose their equipment-rental refund if the rules remain.

Consulting and service firms will have to track billable hours differently if the proposed revenue-recognition rules are issued, says NetSuite chief operating officer James McGeever. The rules call for breaking apart elements of bundled products so a fair-value estimate of each component can be booked. NetSuite, which sells software bundled with implementation services, would have to estimate and keep track of every hour of implementation work that was historically sold under a fixed-price contract. — M.L.